Jan 2018 Comments: How Interest Rates Impact Stock Prices

Last month in our discussion of interest rates, we stated that ”one major interest rate story for the year 2017 deserves additional comment: the fact that while there were three one-quarter point increases in the short-term rates controlled by the Federal Reserve, the ten-year US Treasury rate, set by the marketplace of buyers and sellers, was almost unchanged for the year, starting at 2.45% and ending at 2.41%.” One month later, we see the ten-year yield at 2.71%, a substantial 30 bp rise in one month, clearly indicating that the buyers and sellers of bonds believe interest rates are on the rise. The question now is how much further rates will rise, and the speed at which they do so. As discussed below, a long, drawn-out rate increase should have less negative impact on portfolios by reducing the short-term price declines and thereby allowing the higher rates to offset the lower prices more quickly.

More generally, when interest rates rise, bond prices fall, with more price impact on longer maturity bonds. The tradeoff, as we wrote last month, is that investors owning longer maturity bonds typically earn additional income in return for their willingness to absorb larger price declines in the bond portion of their portfolios, compared to the smaller price declines that occur with shorter-term bonds that pay less interest. These bond price declines, should they occur, are typically modest compared to the extent of potential stock price declines, and bond price declines are offset in part over time by the higher interest received.

This brings us to the discussion of how interest rates impact stock prices. Our first observation is that the connection between interest rates and stock prices is far less clear than the direct impact of interest rates on bond prices. Stock prices are affected by a host of factors, such as the pace of economic growth, expectations of corporate profits, and investor psychology as to the likely future direction of market prices. Interest rates therefore are but one of a number of factors to consider in relation to stock prices.

When economic growth is strong, and corporate profits are increasing, it makes sense for stock prices to rise. But if growth becomes too strong, the Federal Reserve typically raises interest rates in an effort to slow the growth down and avoid (or at least mitigate) the harmful effects of inflation. How does this work in practice? Higher interest rates can slow economic growth by raising the cost of borrowing, which in turn tends to slow spending and reduce corporate profits. In the financial markets, when rates rise, bond prices fall and interest rate payments increase, setting the stage for potential stock price declines, as bonds become a more attractive investment.

The key point to recognize is that in the liquid markets, stocks and bonds compete for an investor’s accumulated savings. Stocks represent an ownership stake in a company’s future profits and offer the potential for significantly higher appreciation (see the period from 2009 to the present), even with significantly more downside risk (see 2008 through March 2009). Investment returns from stocks come from price appreciation (or depreciation) and dividends. Bonds, on the other hand, are a promise to repay a set amount of money in the future, plus interest, and the investment return comes mostly from the interest, with modest price changes (depending on the maturity) until the bonds mature.

When interest rates rise in the marketplace, and bond prices decline, this creates an opportunity for a flow of more income from the higher interest payments, and some number of investors become more likely to reduce their riskier stock holdings and increase the steadier bonds now paying more interest. This provides a rationale for stock price declines even in the face of strong economic growth and strong profits. Of course, how much the prices decline and for how long are always unknowns.

This brings us to a recent “Opinion” article by Professor Burton Malkiel (author of the many editions of “A Random Walk Down Wall Street) on “How to Invest in an Overpriced World”. The article begins by stating that “all asset classes appear overpriced;” bonds because of their low yields and stocks because of their historically high price earnings (P/E) ratios. “Investors have reason to worry, but they need to be aware of two basic facts. First, no valuation metric can dependably forecast the future…. A corollary is that no one can consistently time the market… which involves two decisions, when to get out and when to get back in. Timing both correctly is virtually impossible.”

Malkiel continues by discussing two strategies that can control risk, namely broad diversification and rebalancing. “Broad diversification…. By holding a wide variety of asset classes, investors have historically enjoyed smoother gains during bull markets and gentler losses during bear markets. In a diversified portfolio, declines in stocks are often partially offset by stability in fixed income markets…. Real estate equities, available through REITs, have also tended to stabilize portfolio returns…. Internationally diversified portfolios, including emerging markets, also tend to see less volatile returns over time and better risk adjusted performance.” Additionally, “Rebalancing helps control risk by ensuring your asset allocation has not strayed far from your desired levels. If the strong US stock market has lifted the proportion of domestic stocks in your portfolio to levels that are riskier than desired, it would be appropriate to reduce your equity share…. In general, staying the course in a broadly diversified portfolio is the best strategy when all asset classes appear overpriced.” He then suggests REITs and higher-yielding preferred stocks as potential replacements for positions sold while rebalancing.

The article closes with the advice to keep costs low, and avoid paying one percent for the investments and an additional one percent for the advice. He “recommends passive index funds and exchange traded funds, now available at virtually zero expense ratios, as the best investment vehicles for all investors.”

At Park Piedmont, we are advocates of Professor Malkiel’s advice, and recommend a broadly diversified mix of short and intermediate maturity bonds, along with high yield investments, and a mix of US (including REITs) and international/emerging market stocks, all in an allocation appropriate for each client and implemented mostly with low-cost index funds and ETFs. Periodic rebalancing, a fiduciary relationship with our clients, and advisory fees at the low end of the profession’s fee schedules have all been key aspects of our work on behalf of our clients since our founding some fifteen years ago.